High Yield Bonds

High yield bonds are bonds issued by a corporation that has been assigned below the investment grade threshold by popular credit rating agencies such as below “BBB” from Standard & Poor and below “Baa” from Moody’s due to additional credit risks involved in interest and principal repayment. However, to compensate for higher default risks, these bonds offer attractive returns to investors.

Often referred to as junk bonds, they are more likely to default in comparison to investment-grade bonds and are more volatile in nature. Since these factors attract more risk for investors, the rate of return is generally higher as well. The issuers of corporate high yield bonds are generally start-ups or companies that are capital intensive with a high debt ratio.

High yield bonds are corporate debt securities that usually provide a more attractive interest rate in comparison to investment-grade bonds. These bonds are also more volatile in nature and the risk of default is very much present.

A major attraction of high yield bonds is that it seems to generate both equity-like returns with bond type risks. Studies have shown High yield market has a negative correlation with the government bond market and low positive to zero with equities and investment-grade bonds.

The issuers of these types of bonds are either start-ups or capital-intensive corporates with a significantly high debt ratio. Since there are high chances of these bonds defaulting and low ratings from esteemed companies, they are also referred to as junk bonds. These non-investment grade bonds are split into two major categories- fallen angels and rising stars.

For investors who want to do not want to take the risk of default can mitigate the risk to an extent by investing in a basket of bonds through high yield bonds ETFs.

Let us understand the features of a corporate high yield bond. These factors are quite different from investment-grade bonds and an investor must be thorough with these features before investing their money into this asset class. Let us understand these points from the explanation below.

• High Yield Bond varies with regard to coupon and maturity types. Many of the most common structures are designed to allow issuers to improve cash flow by deferring interest payments.
• The highest yield bond is an unsecured senior debt obligation. By contrast, leveraged loans are usually secured on particular assets.
• Covenant on high yield loans may restrict certain activities or payments by the issuer detrimental to the interest of the creditor. Most high yield loans incorporate a change in control put.
• The primary market for high yield loans is dominated by the small number of major investment banks, whereas secondary markets is an OTC market wherein the bulk of transaction are negotiated between dealers and investor.

Let us understand the different types of junk bonds that might feature in a high yield bonds ETF or bonds of this nature in singularity. This will give us a detailed understanding of the concept and related factors.

• Zero-Coupon Bonds - This issue deep discount and redeemable at par. No interest is accrued and paid to the bondholder
• Deferred Interest - In the deferred interest, no interest payment until later in the bond’s life. Thereafter higher coupons are paid to make up the shortfall.
• Step-Up Bonds - Initial coupons are low, increasing at later dates.
• Pay in kinds of Bonds - It replaces coupons with additional debts. The additional debt will carry a higher coupon rate than the original but are very risky in nature. If the issuer continues to pay in the form of additional debt as the number of outstanding debts of the company will significantly increase.
• Equity-Linked Bonds - Which gives the right to the holder to convert is bondholding to equity holding such as convertible bonds.
• Extendable Reset Notes - The issues have the right to extend the maturity of outstanding debt with the new coupon at periodic intervals. It also has additional features of put options where the investor can sell back the bond to the issuer.

Since most retail investors would not want to expose themselves to so much risk in a debt instrument as it is generally looked upon as a safe investment in comparison to equity or cryptocurrency. Therefore, it is vital to understand who are the typical investors in corporate high yield bonds to understand the concept fully.

• Retail investors do not participate in this market due to a lack of financial and technological resources to monitor key credit issues or day on the daily activities of the borrower. Institutional investors such as Insurance companies (these are one of the big investors who want heavy returns to fund their annuities).
• Pension funds (invest in bonds to increase their earnings but often are subject to regulation in investing in high-risk portfolio), hedge funds or investment funds (these are aggressive investors and invest a large portion of their portfolio in realizing the quick gain and are subject to no regulation) are a major participant in this market.

While researching before investing in this asset class, the prospectus of the issuer can give clarity with regard to their plan and the purpose for which they are raising these funds. However, there are two ways in which an investor can go ahead with their plans of investing in corporate high yield bonds. Let us understand both of them through the discussion below.

• Broker-Dealers: Investors can choose to buy these bonds directly from brokers or deals who shall charge a specific fee for helping them gain access to investing in the bond.
• ETFs: ETFs are a basket of bonds just like mutual funds for equity. Here, a fund manager shall be in charge of choosing the bonds that shall be invested through the portfolio.
• Therefore, based on the risk appetite, time frame, and requirement for control, an investor can choose any of the two options to buy these bonds.

High yield financing has played a prominent role in certain sectors such as technology, media, energy, and IT infrastructure. Companies in these sectors have a high debt burden relative to their earnings and cash flow. Some are startup companies or well-established companies restructuring, or high yield loans are used to finance the leveraged buyout, refinancing existing loans, acquisition, takeovers, etc.

The market index for fallen angels or rising stars indicates the overall movement of the market and also give investors a clearer picture in terms of the right time to invest into the market in the form of singular such bonds or through high yield bonds ETF. Let us understand the indexes through the points below.

• Standard & poor high yield corporate bond index
• CSFB high yield II index
• Bloomberg USD high yield corporate-based index
• FINRA Bloomberg active high yield US corporate bond index
• Barclays high yield index
• Citigroup US high yield market index

Let us understand the advantages of high yield bonds ETF and investing in a singular bond directly from a broker-dealer. This will give us a deep dive into the concept and its intricacies.

• Enhanced Spread -  High yield offers a significant spread over treasury securities. In 1980-1990 US high yield bonds offered 300-500 basis points relative to US treasury of comparable maturity. For some investors, it can fetch significantly higher returns in a small period of time than any other offering.
• Diversification - High yield loans are treated as a separate asset class that exhibits low correlation with other fixed-income securities, which help to provide consistency in returns and lowers overall portfolio risks.
• Security - High yield investors are given priority on repayment of capital over common and preferred stockholders in the event of a liquidation. Many investors feel that High yield investments are not as safe as the entire amount is lost during default, but this is not true as investors do recover some portion before other class of shareholders. In other words, it’s much safer as compared to stock issues by the same company.
• Low Duration - The inclusion of high yield loans in the portfolio will help to lower the overall duration due to shorter maturity. These are typically issued with 8-10 years of maturity and often callable within 3-5 years.

Despite the various advantages mentioned above, there are a few factors that prove to be a disadvantage for investors. Let us understand the disadvantages of investing in corporate high yield bonds through the explanation below.

• Default Risks - During economic stress, defaults may spike, making the asset class more sensitive to the economic outlook. High yield borrowers often fail to make scheduled interests and principal payments, which are very high as compared to conventional loans.
• Downgrade Risks - Due to a change in credit quality, a credit rating downgrade these bonds leading to a significant change in its value.
• Economic Risks - High yield loans are very sensitive to corporate earnings and economic outlook than a day to day fluctuations in interest rate. In the rising interest rate environment, these are expected to outperform other fixed-income loans. However, during economic crises, these are more prone to default.
• Liquidity Risks - Due to its risky nature and limited supply, it’s very difficult to find investors in these markets, which results in lowering the overall liquidity, widening bid-ask spread, and transaction costs.
• Interest Rate Risks - Interest Rate Risk refers to a change in the market value of a bond due to a change in interest rate. However, these are less affected by the increase in interest rate as compared to other fixed-income instruments due to low correlation.
• Event Risks - Event Risk refers to poor management, failure to anticipate shifts in the market, the rising cost of raw material, regulatory changes, change in management, competition can significantly affect the whole industry.